Phil Town’s Rule #1, Part #1

As cynical as I am, there are still forms of human gullibility that surprise me. For example, I am forced to conclude that those Nigerian emails promising tens of millions of dollars must somehow snare a few people, otherwise they wouldn’t get sent. And don’t get me started on Bernie Madoff. I guess it is my dim view of my fellow man that has me scratching my head. I just can’t believe anybody is really that optimistic.

So you will understand how stupefied I am at the sales of the many books that claim to contain a sure-fire way to get rich in the stock market. Individual titles come and go, but there always seems to be a few members of this sub-genre haunting the bestseller lists. (Although at the moment they are relatively less popular. Go figure.)

Hundreds of thousands of people spend hard earned money on these books. Difficult as it is for me to contemplate, it seems inevitable that some of those people read this blog. So with uncharacteristic patience, I am going to review one of the more popular of these tomes, Phil Town’s Rule #1, The Simple Strategy for Successful Investing in Only 15 Minutes a Week. I will do this in several installments, and, just to make it clear now, I will not have anything nice to say.

Hard sales figures for books are hard to come by, but it is clear that Mr. Town has done very well by this, his first book. He can safely be put into the growing club of those who have become rich by selling advice to others on how to become rich. Somebody should tell the Nigerian scammers about this. If only they charged money for their emails.

You do not need to open Rule #1 to know that it most certainly does not contain a recipe for wealth. None of these books do. They can’t. If this is not immediately obvious to you, consider the following.

Suppose you stumbled on a “simple strategy for successful investing” that allowed you to consistently make money in the stock market. Of course, you wish to profit from your discovery, and two possible ways to do that occur to you. You could a) make millions by writing a book that explains your method or b) make billions keeping your mouth shut and running a hedge fund. Which would you choose? Hint: a billion is a thousand millions.

Put another way, suppose you developed a way to play golf especially well. Would you teach it to others at the local country club or join the PGA Tour?

The bottom line is that everybody who can really beat the market does that for a living. They do not write books. And they rarely give interviews. In fact, people with effective schemes for making money in the stock market are generally very secretive about how they do what they do. If everybody knew and used the trick(s) they wouldn’t work so well. Indeed, Madoff could get away with what he did because it is common for hedge funds to disclose very little about what they do, even to their own investors.

Investing may be the ultimate “those that can, do, those that can’t, teach” subject. Because doing just pays so darn well. I know I am being a wet blanket. I just can’t help myself.

Still, I am sure that there is an optimistic fool or two reading this that hopes that maybe Rule #1 will be the exception. Town’s picture on the cover just looks so trustworthy. So in the rest of this series of posts I will methodically examine his simple strategy and I will show how Phil Town is the only person who will ever make a dime from it.

[Links to parts of this review: Part 1, Part 2, Part 3, Part 4, and Part 5]

On Investing Ethically

Two recent posts, one on Christian Personal Finance, the other on Consumerism Commentary, discuss ethical, or as it is known in the trade, socially responsible investing. For those of you blissfully unaware, this is the notion that when investing your money you avoid companies that do things you think are morally reprehensible.

Back when I was just starting out in the investment world I had some involvement in socially responsible investing. I worked for a large institutional money manager. Our clients were pension funds, endowments, and the like and each one had its own account, sort of like a mutual fund with only one shareholder. We had hundreds of them and almost all were perfectly identical, holding the same stocks in exactly the same proportions.

The non-identical ones had “client restrictions.” Most of those were prohibitions against investing in certain industries to which the client, often on religious grounds, objected. I remember we had several accounts associated with the Catholic Church. They prohibited investments in any company even vaguely involved in abortion and in, for reasons I cannot recall, for-profit hospitals. We also had a few accounts associated with the Lutherans, who prohibited us from putting their money in companies that made alcoholic beverages or were involved in gambling. They were fine with abortion and hospitals, just as the Catholics were indifferent to booze and gambling. Another set of accounts prohibited arms makers and we had several different levels of prohibitions against tobacco.

It was an administrative mess and my job (well, a small part of my job) was to simplify and automate things so that the portfolio managers would not have to spend time adjusting each account to accommodate the restrictions. I built a clever system that boiled down to finding a second-choice stock in a similarish business to substitute for a forbidden stock. So, to cite the only example I can remember, when most of the accounts bought cigarette maker Phillip Morris, the no-tobacco accounts got McDonald’s instead.

This was working well for some time when some genius in the marketing department discovered that not only did the restricted accounts have somewhat different returns than the normal account, but that on average they consistently did worse. He called me in a huff and I very patiently explained to him that of course they underperformed. They were supposed to. The normal accounts had the portfolio managers best picks in them. The restricted accounts not so much. Restrictions can only cost you money.

With utmost respect to the moral values of others, I personally think that ethical investing is bogus. To begin with, I have a lot of problems with the idea that one degree of separation from evil is evil but that two degrees of separation is okay. Investing in a company that pollutes is bad, but investing in companies that make money with the electricity made by the polluter is okay? And if it is, why isn’t investing in a mutual fund that then invests in a polluter okay? Wherever the line gets drawn it is arbitrary. We have one big global economy and cleanly excising out the dirty money is not an option.

I am also very uncomfortable with the idea that by investing in a company I am necessarily endorsing everything the company does. I own some Treasury bonds. Does that mean that I endorse everything the Federal Government does? I really hope not.

That said, if you want to invest ethically, as you personally define it, go right ahead. It’s your money and what makes capitalism work is that only you get to decide where it goes. But keep in mind that you are making a sacrifice. Your moral high ground will, over time, cost you money as you pass up unethical but profitable opportunities.

Inflation, Deflation, and You

Every day, people come up to me and say things like:

Frank, what are these inflation and deflation things that I keep hearing about? Are they something I will enjoy? Do I need any special skills to participate?

Inflation is when the prices of everything go up. Put another way, it is when the value of money, US dollars for example, goes down, so it takes more of it to buy the same old stuff. Deflation is the opposite, when prices go down and the value of money goes up.

That sounds like fun for the whole family! What causes inflation and deflation? Are they something I can make at home?

Folks (by which I mean economics professors) used to think that inflation/deflation was caused by changes in things like the level of production and unemployment. Currently, the consensus is that it is a “monetary phenomenon” which means that it is really all about money itself. Inflation is caused by one of two things: an increase in the supply of money in the economy or an increase in the “velocity” of money, how fast it is changing hands in the economy. Deflation is the opposite, caused by a drop in the money supply and/or a fall in the velocity.

The money supply is what people usually watch to predict inflation/deflation because velocity is pretty constant over time. It really only drops in very extreme circumstances, such as the early 1930s and right now.

That sounds awesome. How can I spot inflation or deflation myself? What are some of the exciting things that will happen to me because of it?

Spotting inflation/deflation is easy. Look for prices of the things you buy to go up/down.

Under inflation, what will probably most concern you is that although the prices you pay have gone up, what you get paid may not go up as quickly.

In the long-run, the more significant effect is on the value of dollar-denominated assets you own and debts you owe. Since the value of dollars is decreasing, the value of bank deposits you have and bonds you own will decrease, possibly faster than the interest paid is growing them. On the other hand, the value of your debt also goes down in the same way. In principle, the value of “real” assets, such as your house and shares of stock in companies, do not decline under inflation. In practice, this is not so easy to see because periods of inflation are also often bad times for the economy so the value of assets tends to go down.

Deflation is similar but worse. You will notice things getting cheaper and the amount you get paid may not immediately go down, which will be fun while it lasts. But it is hard for companies to cut salaries. The last time we had meaningful deflation, at the start of the Great Depression, instead of cutting everybody’s salary companies laid off some people and stopped hiring. If you were one of the lucky who still had a job, then things were fairly good since you could buy more with your salary. If you were one of the one third of Americans out of work, things were not good.

The same effect on dollar denominated assets happens under deflation as inflation, but backwards. The value of your bank deposits and bonds increases, but so does the value of your debts. If you have money in the bank you should be rooting for deflation, if you owe money you should be rooting for inflation.

They both sound like a blast. Is there a reason to pick one over the other?

Go with inflation. Deflation has really nasty effects on the economy. If the value of your dollars is increasing every day, you have less incentive to spend or invest them. And if today’s dollars are worth a lot less than the dollars of a few years from now, borrowing money becomes expensive, even at zero percent interest. This can lead to a vicious spiral, with people hoarding money because of deflation, which causes a drop in velocity, which causes more deflation.

Okay, I’m ready to play. What should I expect first, inflation or deflation?

For the moment, we appear to be in a period of deflation. The fiasco in the financial system has caused a lot of people and companies in the economy to hold on to their cash, which has greatly reduced the velocity of money. But the Fed and the government have made it clear that they will go to whatever extremes necessary to keep deflation from setting in for long. Fed Chairman Bernanke has hinted that if he has to he will fly over cities in helicopters dropping cash. Bernanke believes that the Fed caused the Great Depression by not increasing the money supply when it should have (in fact it decreased it) and he has made it his life’s mission that that particular debacle not be repeated.

The medium- and long-term effect of the massive increase in the money supply now under way should be obvious. Velocity will stabilize and/or rise and we will get inflation. Lots of it. Inflation is good news for debtors, those that owe dollar-denominated debts. And who is the largest dollar-denominated debtor in the world? Not at all coincidentally, the US Federal Government. Runner up are American homeowners, who could use a break.

Predicting Stock Market Returns

Amongst the nice things about blogging is that you get to write your own headlines. I imagine that Jason Zweig isn’t all that happy with his editor’s “hed” for his column today in the Wall Street Journal. It reads “Why Market Forecasts Keep Missing the Mark.” I was a little disappointed, but not really surprised, to find that the column doesn’t really address that good question at all.

So I will try. How hard could it be?

Market forecasts, such as “the Dow will be up 14% in 2009″ are doomed to failure because the market is impossible to forecast.

That was easy.

Some things are forecastable. The weather, for example. Or how many votes a candidate will get in an election. You can look at certain data, do a little math, account for a special factor or two, and presto, a useful estimate of the near future.

But for other things you really can’t create a useful estimate. The score in the next Super Bowl. The next roll of the dice. It is not that you are stupid or lack data. And it is not that you don’t understand what is going on. You can say some useful things about these unforecastable future events. The Steelers are heavily favored. Seven is the most likely dice roll, and fourteen just ain’t gonna happen. But these are not predictions, they are statements about likelihoods and probabilities.

So it is with the stock market. (And for that matter, the bond market, commodity markets, etc.) Occasionally somebody will throw out a prediction like “the Dow will be up 14%” but nobody, the speaker included, expects it to be taken very seriously.

Sober predictions about the stock market are really estimates of the so-called expected outcome, the probability weighted average of all possible outcomes. E.g. seven is the expected outcome of a roll of two dice. The most common way to come up with an expected outcome for a year in the stock market is to average historical performance. Depending on which years are used, and which indexes, the answer is usually something like 10-12%.

So a personal finance pundit will tell you to expect 10% average annual returns in the stock portion of your investment portfolio. That’s a reasonable thing to say, but I think that too many people, possibly including the pundits, misunderstand what it means.

Imagine that on January 1, 2006, based on being told to expect 10% annual returns in the stock market, you invested $100. With the help of Microsoft Excel, you work out that you should have $672.75 on January 1, 2026. But over the next three years the investment actually goes down, so your January 1, 2009 balance is $81.88. Now what is your expected 2026 value?

Way too many people would say $672.75 or something like it. They think that the 10% number they were given was a forecast of what was actually going to happen over twenty years, rather than an estimate of the expected outcome for each year. Put another way, they think that the market has a memory, that it will remember it had some bad years and make up for it in the future, in order to return to the “normal” long-run average.

Well, sorry kids, it just don’t work that way. The 10% number may still be sound as an annual estimate. Assuming it is, then 17 years at 10% compounds to 405.44%. Starting with $81.88, the expected value on January 1, 2026 is now $413.86. Sorry ’bout that.

The Great Life Cycle of Risk Aversion Fallacy

If there is a single bit of established personal finance wisdom that is most popularly accepted and most wrong, it is what I call the Life Cycle of Risk Aversion. I have to name it myself because it is so widely assumed to be so obviously true that hardly anybody even notices it.

The Life Cycle of Risk Aversion is the idea that as you get older you should take fewer risks in your investment portfolio. When young, you should invest aggressively in stocks and similar exciting things. As you age, you temper your investments gradually into bonds and the like, until in retirement you have an all-boring portfolio.

This unspoken assumption of retirement planning is so pervasive that right about now you are probably wondering if I am really crazy enough to challenge it. Before clicking away, imagine the following “thought experiment.”

Suppose you are 25 years old and your great-uncle leaves you a very strange bequest. You get a million dollars, but only to be used for your retirement in 40 years. The terms of the will say that you must hire a money manager and, although you can talk to him all you want now, once he gets the money no communications are allowed until you are 65, when you get full control over the money.

What instructions would you give the manager before he sets off on his 40 year mission? Would you, for example, tell him to invest aggressively at the start but taper down to conservative investments in the final decade? If that makes sense to you, consider that investment results are multiplicative. The returns from each of the forty years are equally important to the final value of the portfolio. (Annual returns of +10%, -5%, +22% and -3% will always result in a four year return of +23.7% no matter what order they came in.) So as far as you know, starting out risky and ending safe has exactly the same expected result as starting safe and ending risky.

If risky-start-safe-end doesn’t make sense as a plan for this blind investment plan, then why would it make sense as generic advice to those saving for retirement? Well, of course, it doesn’t.

To be clear, there are many reasonable circumstances in which a person might want to reduce risk as they got older. A 55 year-old who has done well in his investments and is on an easy glide path to retirement might not want to jeopardize that to possibly make more money than he really needs. Alternatively, the same guy who has done poorly might want to reduce his risk so as to hold on to what he has left and fund at least a modest lifestyle.

If those two examples of rational risk reduction in late middle age have you convinced that maybe I am wrong, consider that a desire to increase risk in both those situations could be equally rational. The richer 55 year-old could decide to swing for the fences, reasoning that either he can live large in his golden years or, at worst, even if he loses half his kitty he can still be pretty comfortable. The poor 55 year-old might reason that he has some serious catching up to do and he is willing to accept the risk of possibly having to live off Social Security.

The point is that how much risk you should take on has a little to do with how much money you have got, a lot to do with your level of risk aversion, and just about nothing to do with your age. And risk aversion, even though it can be described with fancy math, is ultimately simply a personal matter of psychology. There is no logical argument to make that the 55 year-old who wants to increase risk is wrong, and therefore no reason to advise 55 year-olds in general to reduce risk in their investments.

So why is this universally accepted wisdom? My theory is that it is because in the late 20th Century, when this idea took over, risk aversion was well correlated with age. Folks born in 1915, who came of age in the depression, were much less willing to invest in risky things than those born in 1945, who in turn were considerably more cautious than my cohorts born in 1965, who learned about investing in the ‘80s and ‘90s.

If present trends continue, I expect that my kids’ generation will be much more risk averse than mine. So in a decade or two personal finance blogs (and books, if they still exist) will drop the idea that you should reduce risk as you get older. Or, possibly, they will come up with a reason why you should take on risk in mid-life but not before or after, to accommodate the inclinations of the various generations in their readership.